LightInTheBox Holding Co. debuted on the NYSE yesterday, jumping 22% in its first day of trading. It has been a long drought in the U.S. IPO market, and many investors are hoping that this is a sign that the MOU between the PCAOB and Chinese regulators might remove enough uncertainty to get the money flowing again.
But just as it looks like it might be safe to get back in the water, up comes the VIE problemagain. Neil Gough had an interesting piece in Dealbook about the late Hong Kong tycooness Nina Wang. It turns out Ms. Wang was using a VIE-like structure to control a Chinese bank starting back in 1995. The VIE and its owner apparently decided to ignore the contracts put in place to give Ms. Wang control, leading her to sue in 1997. Chinese courts can operate slowly, and the case finally led to a ruling by China’s Supreme People’s Court last October. The ruling is a stunner. The court ruled the contractual arrangements invalid because they had clearly been intended to circumvent China’s restrictions on foreign investment, and amounted to “concealing illegal intentions with a lawful form”.
To add to the problem, an article by two Shanghai attorneys in the China Business Law Journal reports that there were two arbitration cases in front of the Shanghai Sub-Commission of the China International Economic and Trade Arbitration Commission that both decided that VIE arrangements were invalid.
If we were in the U.S. and Nina Wang’s case was based on U.S. law, it would be game over for VIEs. It is not so clear in China. I need to venture outside my field and talk about Chinese law. Accounting and law are often intertwined. I am about to go out of my depth and I hope some of the wise legal scholars in this area – like Donald Clarke of GW – can set the record straight.
China has civil law system, contrasted with the common law system that U.S. law is based upon. Common law relies heavily on precedent – once an issue is decided there is a strong bias against deciding it differently. Common law has a concept that contracts that frustrate public policy are not enforceable. China happens to have the same concept, but it is part of the statute in China. That is the statute that the Supreme People’s Court is applying.
If this case all took place in the U.S. under common law, I do not believe that lawyers could responsibly continue to give opinions that VIE contracts are enforceable. But I understand that is exactly what they plan to do in China. That is because under Chinese law even a decision by the Supreme People’s Court does not establish precedent. The court could hear similar cases again and again and reach different conclusions. I am certain the lawyers will caveat their opinions heavily, but they will be able to put in the key words that the SEC is looking for –“the arrangements are legal and enforceable under Chinese law”. They can do that even though no one has ever succeeded in enforcing the agreements and every time it has come before a judge or arbitrator the agreements have been found invalid. As long as the agreements are not disputed, they will work just fine.
That leaves accountants, the SEC, and investors in a pickle. By legal sleight of hand lawyers can say that VIE agreements are enforceable. Until of course there is a dispute and a judge is asked to rule on them. And then they will not be enforceable, unless the judge decides to ignore the law and other decisions, which he would be entitled to do. Therein lies the problem for accountants. They need to make a judgment on whether it is probable that the company has control of its VIE, and they cannot weasel out of that call with all the qualifiers that the lawyers will be putting in their opinions. I seriously question whether auditors can conclude that it is probable that the VIE contracts can be enforced. And if they cannot reach that conclusion, it leads to deconsolidation of the VIE.
I also cannot see that any accounting firm will take this position. They would immediately lose all of their VIE clients to other firms with a more sympathetic view. Lawyers are under the same pressure. The VIE is too critical to the ecosystem of law and accounting firms in China for any of them to undermine it.
The SEC is in a similar pickle. They have known for a long time that VIE agreements don’t really provide control, but they have been forced to accept the legal opinions of Chinese lawyers who say that the contracts are enforceable.
This creates enormous risk for investors. Where else would investors take ownership risk of this nature?
The VIE needs to be fixed, and it is China that needs to do the fixing. The way that Chinese companies go to international markets needs to change, getting rid of the Cayman Island holding companies and VIEs. The way to do that is for China to focus on avoiding foreign control of companies in sensitive sectors, rather than just banning foreign investment in those sectors. I have written about this before. These reforms will not be easy, but China's entrepreneurs need them.